'We do not see upside': London-based analyst calls 'neutral' after Snap's London IPO road show

Snap Inc. CEO Evan Spiegel at the Vanity Fair New Establishment Summit at Yerba Buena Center for the Arts in 2014 in San Francisco. Getty/Michael Kovac Snap Inc. took its initial-public-offering road show to London on Monday, looking to persuade potential UK investors to buy up the company's stock, but one London-based analyst remains "neutral" about the company's ability to drive upside beyond its initial price range of $14 to $16 a share.

Atlantic Equities research analyst James Cordwell did not attend the presentation on Monday but spoke with clients who did. (Atlantic Equities is also not one of the banks underwriting Snap's IPO.)

In a detailed research note, Cordwell set a $14 price target for Snap's stock for the end of this financial year. That would imply a market cap of $19.5 billion.

He said while the Snapchat app was an "impressive 'made for mobile' service" that was popular among young users, it would be difficult to expand its audience base beyond this demographic. And, all the while, competition is intensifying from Facebook, which is adding Snapchat-like features to many of its major properties, including Instagram, Messenger, and, most recently, WhatsApp.

Cordwell wrote: "With expansion beyond the core audience likely challenging, sustainability of engagement concerns to persist, and margins structurally lower than peers, we do not see upside to the $14-$16 IPO valuation range."

Revenue projections

Snap generated $404.5 million in revenue in 2016, according to its S-1 filing with the Securities and Exchange Commission. Cordwell thinks that may rise to $1.13 billion this year. Cordwell projects revenue will increase to $2.16 billion in 2018, rising to $3.03 billion in 2019.

Snapchat's average revenue per user is less than 15% that of Facebook, a fact Cordwell said demonstrated a "clear opportunity for significant near-term revenue growth."

But Cordwell assumes Snap will reach only 55% of Facebook's current monetization level by 2020, given Snapchat's heavy skew toward developed markets, its demographic skew toward younger users who are less likely to spend on advertisers' products, and the smaller amount of user data Snapchat has compared with Facebook, which could limit its potential among direct-response advertisers.

Atlantic Equities Snapchat will need to match Facebook's monetization levels on a per-hour basis if it is to ramp ad spending beyond the $2 billion a year at which Twitter began to run into revenue growth issues, Cordwell predicted.

Smaller margins compared with its peers

Snap's margins are lower than its peers', a reality Cordwell says is owing to the infrastructure costs required to deliver messaging centered on videos and photos, the revenue it shares with publishers in exchange for their content, a focus on direct sales versus self-serve, and its research-and-development costs.

Cordwell predicted Snap wouldn't reach non-GAAP (generally accepted accounting principles) profitability until at least the end of 2019 — with its GAAP operating margin in the long term unlikely to be higher than 15%. By comparison, Facebook is at about 45%.

Atlantic Equities Snap posted adjusted EBITDA (earnings before interest, tax, deprecation, and amortization) loss of $459.4 million in 2016. Cordwell predicted that loss would widen slightly to $482 million in 2017 before coming down to $184 million in 2018 and then turning to profitability of $44 million in 2019.

"Our price target effectively assumes Snap trades at over 50x FY20 EBIT (earnings before interest and tax) multiple at YE19, well in excess of the historical range of this metric for Facebook, though Snap's margins still likely to be below structural potential at this point."

Cordwell says Snap will need to gain better leverage on its tech spending and improve its sales efficiency to become profitable.

Snap has been pitching itself to investors as a "camera company," which would imply that it does not want to become wholly reliant on ad sales in the future. So far, Snap's only hardware product is Spectacles, the camera glasses it launched last year that are available only in the US.

Cordwell doesn't think Snap's hardware products will be a near-term profit driver, but he notes that new products focused on "mixed reality" could help drive the company's stock multiple.

He writes: "To drive upside to the IPO range it seems necessary to believe Snap can leverage its AR (augmented reality)-style features and hardware efforts into a strong position in 'mixed reality', but it seems too early to attach value to this opportunity."

Earlier on Tuesday, Reuters reported that while investors attending the London leg of the Snap IPO road show were impressed with "sleek" presentation, some were disappointed the company did not provide projections on future revenue and advertising share.